IE 442: Operations Research

Chapter 2: Decision Analysis

1
Introduction to Decision Analysis

• The field of decision analysis provides a framework

for making important decisions.
• Decision analysis allows us to select a decision from
a set of possible decision alternatives when
uncertainties regarding the future exist.
• The goal is to optimize the resulting payoff in terms
of a decision criterion.
2
2
Introduction to Decision Analysis…
• Maximizing expected profit is a common criterion
when probabilities can be assessed.

• Maximizing the decision maker’s utility

function is the mechanism used when risk
is factored into the decision making
process.
3
Payoff Table Analysis
• Payoff Tables
• Payoff table analysis can be applied when:
• There is a finite set of discrete decision alternatives.
• The outcome of a decision is a function of a single future event.
• In a Payoff table -
• The rows correspond to the possible decision alternatives.
• The columns correspond to the possible future events.
• Events (states of nature) are mutually exclusive and collectively
exhaustive.
• The table entries are the payoffs.

4
INVESTMENT DECISION
• Tom Brown has inherited $1000.
• He has to decide how to invest the money for
one year.
• A broker has suggested five potential
investments.
• Gold
• Junk Bond
• Growth Stock
• Certificate of Deposit
• Stock Option Hedge

5
INVESTMENT DECISION…
• The return on each investment depends on the
(uncertain) market behavior during the year.
• Tom would build a payoff table to help make the
investment decision

6
Solution

• Construct a payoff table.

• Select a decision making criterion, and apply
it to the payoff table.

• Identify the optimal decision.

• Evaluate the solution. S1 S2 S3 S4 Criterion

D1 p11 p12 p13 p14 P1

D2 p21 p22 p23 P24 P2
D3 p31 p32 p33 p34 P37
 The Payoff Table

Decision States of Nature

Alternatives Large Rise Small Rise No Change Small Fall Large Fall
Gold -100 100 200 300 0
Bond 250 200 150 -100 -150
Stock 500 250 100 -200 -600
C/D account 60 60 60 60 60
Stock option 200 150 150 -200 -150

The states of nature are mutually

exclusive and collectively exhaustive.
8
 The Payoff Table

Decision States of Nature

Alternatives Large Rise Small Rise No Change Small Fall Large Fall
Gold -100 100 200 300 0
Determine the
Bond 250 200 150 -100 -150
set of possible
Stock 500decision250 100 -200 -600
C/D account 60alternatives.
60 60 60 60
Stock option 200 150 150 -200 -150

9
 The Payoff Table

Decision States of Nature

Alternatives Large Rise Small Rise No Change Small Fall Large Fall
Gold -100 100 200 300 0
Bond 250 200 150 -100 -150
Stock 500 250 100 -200 -600
C/D account 60 60 60 60 60
Stock option 200 150 150 -200 -150

The stock option alternative is dominated by the

bond alternative 10
Decision Making Criteria

• Classifying decision-making criteria

• Decision making under certainty.
• The future state-of-nature is assumed known.
• Decision making under risk.
• There is some knowledge of the probability of the states of nature
occurring.
• Decision making under uncertainty.
• There is no knowledge about the probability of the states of nature
occurring.

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Decision Making Under
Uncertainty
• The decision criteria are based on the decision maker’s
attitude toward life.
• The criteria include the
• Maximin Criterion - pessimistic or conservative approach.
• Minimax Regret Criterion - pessimistic or conservative approach.
• Maximax Criterion - optimistic or aggressive approach.
• Principle of Insufficient Reasoning – no information about the
likelihood of the various states of nature.

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Decision Making Under Uncertainty -
The Maximin Criterion
• This criterion is based on the worst-case scenario.
• It fits both a pessimistic and a conservative decision
maker’s styles.
• A pessimistic decision maker believes that the worst
possible result will always occur.
• A conservative decision maker wishes to ensure a
guaranteed minimum possible payoff.

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 Example - The Maximin Criterion

• To find an optimal decision

• Record the minimum payoff across all states of nature for
each decision.
• Identify the decision with the maximum “minimum payoff.”

The
TheMaximin
MaximinCriterion
Criterion Minimum
Minimum
Decisions
Decisions Large
LargeRise
Rise Small
Smallrise
rise NoNoChange
Change Small
SmallFall
Fall Large
LargeFall
Fall Payoff
Payoff
Gold
Gold -100
-100 100
100 200
200 300
300 00 -100
-100
Bond
Bond 250
250 200
200 150
150 -100
-100 -150
-150 -150
-150
Stock
Stock 500
500 250
250 100
100 -200
-200 -600
-600 -600
-600
C/D
C/Daccount
account 60
60 60
60 60
60 60
60 60
60 60
60
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Decision Making Under Uncertainty -
The Minimax Regret Criterion

• The Minimax Regret Criterion

• This criterion fits both a pessimistic and a
conservative decision maker approach.
• The payoff table is based on “lost opportunity,”
or “regret.”
• The decision maker incurs regret by failing to
choose the “best” decision.

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Decision Making Under Uncertainty -
The Minimax Regret Criterion
• The Minimax Regret Criterion
• To find an optimal decision, for each state of nature:
• Determine the best payoff over all decisions.
• Calculate the regret for each decision alternative as the
difference between its payoff value and this best payoff value.
• For each decision find the maximum regret over all states
of nature.
• Select the decision alternative that has the minimum of
these “maximum regrets.”

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 Decision Making Under Uncertainty -
The Maximax Criterion
• This criterion is based on the best possible scenario.
It fits both an optimistic and an aggressive decision
maker.

• An optimistic decision maker believes that the best

possible outcome will always take place regardless of the
decision made.

• An aggressive decision maker looks for the decision with

the highest payoff (when payoff is profit).
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Decision Making Under Uncertainty - The
Maximax Criterion

• To find an optimal decision.

• Find the maximum payoff for each decision alternative.
• Select the decision alternative that has the maximum of
the “maximum” payoff.

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 Example - The Maximax Criterion

The Maximax Criterion Maximum

Decision Large rise Small rise No change Small fall Large fall Payoff
Gold -100 100 200 300 0 300
Bond 250 200 150 -100 -150 200
Stock 500 250 100 -200 -600 500
C/D 60 60 60 60 60 60

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 Decision Making Under Uncertainty - The
Principle of Insufficient Reason

• This criterion might appeal to a decision maker who is

neither pessimistic nor optimistic.
• It assumes all the states of nature are equally likely to occur.
• The procedure to find an optimal decision.
• For each decision add all the payoffs.
• Select the decision with the largest sum (for profits).

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The Principle of Insufficient Reason…

• Sum of Payoffs
• Gold 600 Dollars
• Bond 350 Dollars
• Stock 50 Dollars
• C/D 300 Dollars
• Based on this criterion the optimal decision
alternative is to invest in gold.

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Decision Making Under Risk

• The probability estimate for the occurrence of

each state of nature (if available) can be
incorporated in the search for the optimal
decision.
• For each decision calculate its expected payoff.

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Decision Making Under Risk –
The Expected Value Criterion

• For each decision calculate the expected payoff as

follows:

Expected Payoff = S(Probability)(Payoff)

(The summation is calculated across all the states of

nature)

• Select the decision with the best expected payoff

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 The Expected Value Criterion

The Expected Value Criterion Expected

Decision Large rise Small rise No change Small fall Large fall Value
Gold -100 100 200 300 0 100
Bond 250 200 150 -100 -150 130
Stock 500 250 100 -200 -600 125
C/D 60 60 60 60 60 60
Prior Prob. 0.2 0.3 0.3 0.1 0.1

EV = (0.2)(250) + (0.3)(200) + (0.3)(150) + (0.1)(-100) + (0.1)(-150) = 130

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When to use the expected value
approach

• The expected value criterion is useful generally in

two cases:
• Long run planning is appropriate, and decision
situations repeat themselves.
• The decision maker is risk neutral.

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Decision Trees
• The Payoff Table approach is useful for a non-
sequential or single stage.

• Many real-world decision problems consists of a

sequence of dependent decisions.

• Decision Trees are useful in analyzing multi-stage

decision processes.

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Characteristics of a decision tree
• A Decision Tree is a chronological representation of
the decision process.
• The tree is composed of nodes and branches.
Chance A branch emanating from a
node decision node corresponds to a
P(S2)
Decision decision alternative. It includes a
node cost or benefit value.

A branch emanating from a state of

P(S2) nature (chance) node corresponds to a
particular state of nature, and includes
the probability of this state of nature.
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Example

• BGD plans to do a commercial development on a property.

• Relevant data
• Asking price for the property is 300,000 dollars.
• Construction cost is 500,000 dollars.
• Selling price is approximated at 950,000 dollars.
• Variance application costs 30,000 dollars in fees and expenses
• There is only 40% chance that the variance will be approved.
• If BGD purchases the property and the variance is denied, the property
can be sold for a net return of 260,000 dollars.
• A three month option on the property costs 20,000 dollars, which will
allow BGD to apply for the variance.

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Example…

• A consultant can be hired for 5000 dollars.

• The consultant will provide an opinion about the
approval of the application
• P (Consultant predicts approval | approval granted) = 0.70
• P (Consultant predicts denial | approval denied) = 0.80
• BGD wishes to determine the optimal strategy
• Hire/ not hire the consultant now,
• Other decisions that follow sequentially.

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 Solution

• Construction of the Decision Tree

• Initially the company faces a decision about hiring the
consultant.

• After this decision is made more decisions follow regarding

• Application for the variance.
• Purchasing the option.
• Purchasing the property.

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The Decision Tree 0
3

Buy land Apply for variance

-300,000 -30,000

Apply for variance

-30,000

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The Decision Tree

Buy land and -300000 – 30000 – 500000 + 950000 = 120,000

apply for variance Build Sell
-500,000 950,000

-300000 – 30000 + 260000 = -70,000

Sell
260,000
Buy land Build Sell
-300,000 -500,000 950,000
100,000
12

Purchase option and -50,000

apply for variance
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The Decision Tree

This is where we are at this stage

Let us consider the decision to hire a consultant
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 Done -5000

Buy land Apply for variance

-300,000 -30,000

Apply for variance

-30,000
Let us consider the
decision to hire a -5000
consultant
Buy land Apply for variance
-300,000 -30,000

Apply for variance

The Decision Tree -30,000
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The Decision Tree

115,000
Build Sell
-500,000 950,000

?
-75,000
Sell
? 260,000

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The Decision Tree

115,000
Build Sell
-500,000 950,000

?
-75,000
Sell
? 260,000

The consultant serves as a source for additional information

about denial or approval of the variance.

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The Decision Tree

115,000
Build Sell
-500,000 950,000

?
-75,000
Sell
? 260,000

Therefore, at this point we need to calculate the

posterior probabilities for the approval and denial
of the variance application

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The Decision Tree

115,000
Build Sell
23 -500,000 24 950,000
25

22
?
.7
-75,000
Sell
?
.3 26 27
260,000

Posterior Probability of (approval | consultant predicts approval) = 0.70

Posterior Probability of (denial | consultant predicts approval) = 0.30
The rest of the Decision Tree is built in a similar manner.

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The Decision Tree
Determining the Optimal Strategy

• Work backward from the end of each branch.

• At a state of nature node, calculate the expected

value of the node.

• At a decision node, the branch that has the highest

ending node value represents the optimal
decision.

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 The Decision Tree
Determining the Optimal Strategy
115,000 115,000 115,000
115,000 115,000 115,000
115,000
Build Sell
23 -500,000 24 950,000
25
58,000 0.70
? -75,000 -75,000 -75,000 -75,000
22 -75,000 -75,000
-75,000
Sell
0.30
? 26 27
260,000

With 58,000 as the chance node value,

we continue backward to evaluate
the previous nodes. 40
 The Decision Tree
Determining the Optimal Strategy
$115,000
Build,
$10,000 Sell

$20,000
$58,000
Buy land; Apply
$20,000 for variance

$-5,000
Sell
land
$-75,000
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